Financial Reform and Fiscal Discipline

Submitted by Eliana Cardoso
On Tue, 02/09/2010

It was in 1714 that Bernard de Mandeville[1] defended his view of the economic world in a long poem with pretensions to uncovering the moral basis of modern society – The Fable of the Bees: Private Vices, Public Benefits[2]. According to him, industrialists, businessmen and politicians are like pimps, quacks, pickpockets and forgers: tireless professionals who, through their cunning, use the work of others for their own purposes. Mandeville[1] claims that it matters little if every trade and place is tainted by trickery and every profession, by chicanery. What does matter is that everyone, whether saint or sinner, contributes to producing the comforts progress provides, by looking after their own interests.

But you and I believe that where people live off ill-gotten gains the community will suffer and, thus, we reject the poem’s cynical view of the world. Yet, the lesson of The Fable of the Bees[2] (that civilization advances in the measure that individuals seek to satisfy their needs and desires) is still alive and kicking.

A contrasting view is found in Memoirs of Extraordinary Popular Delusions and the Madness of Crowd[3] (1841) by Charles Mackay[4]. The author takes a deep look at financial bubbles when fortunes are made and lost amidst monumental speculation. He does not limit himself to financial speculation, though. He writes an entire chapter on a 16th century European craze: that of poisoning unwanted husbands with potions that simulate natural illness. This method, in use since Ancient Greece, became such a problem in England that King Henry VIII decreed a law condemning those judged guilty of the crime to being boiled to death.

Even more common in Italy, the practice was seen as a legitimate means of ridding oneself of one’s enemies. In the 16th and 17th centuries, Italians would poison their foes with the same offhandedness that political parties today collect corporate contributions for their slush funds. Sales of arsenic led to a lucrative trade. The custom spread to France and became commonplace between 1670 and 1680. Poison dominated popular imagination and the jails filled up with those who were too timid to use a knife or gun, but wouldn’t think twice about using that most sought after of liquid weapons. The slow poisoning trend passed only after more than a hundred prisoners had met grisly ends atop bonfires or at the end of the hangman’s noose.

Through the use of such fabulous stories, Charles Mackay[4] pointed out that Man does not act based on rational reasoning alone, while seeking to maximize his utility. From time to time, the foolish will let themselves be led into a new craze. This point is well taken by those who advocate regulation and supervision in financial markets.

To deal with the inability of banks and their regulators to grasp and contain systemic risk from highly leveraged operations, governments will have to create more effective and transparent rules for loss provisions, pro-cyclical capital buffers, and a resolution framework to increase liquidity requirements of institutions judged too big to fail. Yet, regulation and supervision alone are not enough to deal with excess liquidity, the greedy search for yield and too little capital to support ballooning debt in all sectors of the economy, as happened in the U.S. before the credit crunch of 2008-09.

In India, fiscal discipline will be an essential part to the process of financial reforms. A more flexible exchange rate and a more open capital account require Indian fiscal policy to play a role as a demand management tool. A disciplined fiscal policy and a declining ratio of public debt to GDP would free up monetary policy to focus on price stability.

Furthermore, the independence and credibility of monetary policy could be compromised if budget deficits continue to grow. Prospects of large deficits make it harder to manage inflationary expectations.

The size of government budget deficits also matters for financial reforms, because the deficit is partially financed by getting banks to buy government bonds. Durable reductions in the fiscal deficit and public sector borrowing requirements are crucial to reduce the constraints on monetary policy.

Do you agree that fiscal consolidation would allow financial sector reforms to proceed with more ease?